Large Universal Banks Research Articles

The German bank–growth nexus revisited: savings banks and economic growth in Prussia†

AbstractThis article provides evidence that smaller, regional public financial intermediaries contributed to Germany's industrial development, using a new dataset of the foundation year and location of Prussian savings banks. This extends the bank–growth nexus beyond its traditional focus on large universal banks. Since savings banks were public financial intermediaries, our results further suggest that state intervention can be successful in the financial sector, particularly at the early stages of industrial development when capital requirements are manageable, and access to international capital markets is limited.

The politics of bank structural reform: Business power and agenda setting in the United Kingdom, France, and Germany

AbstractFollowing the financial crisis, the United Kingdom introduced major structural reforms to address concern about Too-Big-To-Fail (TBTF) banks, while France and Germany adopted much weaker reforms. This is puzzling given the presence of large universal banks engaged in market making activities in all three countries, which suffered significant losses during the international financial crisis, and given the commitments to reform made by political leaders in all three countries. The paper explains this policy divergence by analysing how dynamics of agenda setting contributed to the emergence of policy windows on structural reform. We explain the United Kingdom's decision to delegate the process to an independent commission as an example of venue shifting which helped to insulate the process from industry framing, and resulted in “conflict expansion” by mobilizing a wider coalition of actors in support of bank ringfencing. By contrast, in France and Germany the agenda was tightly managed through existing institutional venues, enabling industry to resist the framing of the issue around TBTF and limiting the role of non-business groups—a process we label as “conflict contraction.” We argue that analysis of agenda setting dynamics provides new insights into the cross-national variability of business power.

Securitisation, Ring-Fencing, and Housing Bubbles: Financial Stability Implications of UK and EU Bank Reforms

Declines in property markets played a central role in the Great Financial Crisis. Off-balance sheet financing activities, particularly securitisations, were used to fund higher volumes of bank lending, concentrated in real estate. In response to the current low appetite for securitisations, the European Union has proposed a new Securitisation Regulation, with the aim of restarting EU securitisation markets. This article explores the possible legal and economic significance of this Regulation and argues that the proposed approach to regulating securitisation is likely to be deficient. Instead of addressing flaws in the securitisation process through improved incentives—which I term ‘process-focused’ regulation—regulation ought to concentrate on the excessive credit-origination which securitisation may facilitate. This is particularly relevant to housing bubbles, which in general are driven by over-optimistic expectations about future house prices, shared amongst lenders, borrowers, and investors. Improving incentives in credit-channel widening structured finance when all parties are over-optimistic is unlikely to guard against future bubble formation. This is particularly relevant to the UK market in light of structural reforms to the UK banking sector (so-called ‘ring-fencing’), which is likely to result in today’s large universal banks being converted into monoline mortgage lenders.

Securitisation, Ring-Fencing and Housing Bubbles: Financial Stability Implications of UK & EU Bank Reforms

Declines in property markets played a central role in the Great Financial Crisis. Off-balance sheet financing activities, particularly securitisations, were used to fund higher volumes of bank lending, concentrated in real estate. In response to the current low appetite for securitisations, the European Union has proposed a new Securitisation Regulation, with the aim of restarting EU securitisation markets. This article explores the possible legal and economic significance of this Regulation and argues that the proposed approach to regulating securitisation is likely to be deficient. Instead of addressing flaws in the securitisation process through improved incentives – which I term ‘process-focused’ regulation – regulation ought to concentrate on the excessive credit-origination which securitisation may facilitate. This is particularly relevant to housing bubbles, which in general are driven by over-optimistic expectations about future house prices, shared amongst lenders, borrowers and investors. Improving incentives in credit-channel widening structured finance when all parties are over-optimistic is unlikely to guard against future bubble formation. This is particularly relevant to the UK market in light of structural reforms to the UK banking sector (so-called “ring-fencing”), which is likely to result in today’s large universal banks being converted into monoline mortgage lenders.

The Plight of Modern Markets: How Universal Banking Undermines Capital Markets

This paper explains the process of competitive deregulation that led both the US and the UK to embrace universal banking and to abandon the functional separation of financial activities that had long characterized their financial systems. The paper argues that some of the consequences of favouring universal banking over functional separation that were understood in the 1930s were rarely voiced in years preceding deregulation. The principal argument offered in favour of separation was that the commercial banking system, which is supported by a government ‘safety net’, needs to be protected from the risks inherent in investment banking. By contrast, this paper argues that functional separation played an important role in protecting capital markets from the banking system.Universal banking is associated historically with thinly traded stock markets, and this paper argues that universal banking promotes the formation of a small group of large dealer‐banks which dominate the financial system and whose interests are best served by trading on nonpublic over‐the‐counter (OTC) markets. The paper finds that just such a group played a key role in the growing importance of such OTC markets in the US over the past few decades.The paper then argues that the benefits of the greater liquidity that large universal banks can provide to capital markets are offset by the dangers they create when they err. Because mistakes at these large banks are often allowed to grow in size to match the size of the banks, they distort prices on financial markets and sometimes create systemic risk. Two recent examples are given: J.P. Morgan Chase Bank's ‘London whale’ fiasco and UBS, Merrill Lynch and Citibank's exposures to subprime mortgages.Finally, the paper explains that the Senate Report on the Glass–Steagall Act indicates that the Act was designed in part to limit commercial bank participation in the margin loan market, as this activity makes possible a feedback loop between increases in the money supply and increases in asset prices, which in turn can generate an asset price bubble in capital markets. The recent crisis has led modern researchers to rediscover the relationship between margin lending, feedback loops, and asset price bubbles that was well understood by at least some legislators in the 1930s. The paper argues that the recent crisis demonstrates that modern banking regulation needs to be informed by an understanding of the consequences that may arise when a financial system is dominated by universal banks.

Can the Credit Default Swap Market Be Salvaged? Issues for Borrowers and Investors

Trading volumes in credit default swaps (CDS) have fallen by more than 75% since the 2008 financial crisis to less than $9 trillion notional amount outstanding as of June 2015. This dramatic decline in volumes comes, in part, because of new laws and regulations focused on reducing the risk of these over-the counter (OTC) derivatives products. Despite significant changes in the regulation of these products, there remain a number of defects in the market structure of OTC credit derivatives, flaws which arguably intensified the impact of the 2008 financial crisis and disadvantage both borrowers and investors. These defects in market structure limit competition, make it difficult for investors to understand the risks taken by large universal banks, create the potential for the manipulation of borrower credit spreads, and even affect the recognition of when default events occur under CDS contracts.

Commercial and Investment Banks United or Divided?

The concept of separation of commercial and investment banking has been the subject of debate since the great depression of the 1930’s. The US Congress saw the need to separate the two activities through the enactment of the Glass-Steagall Act of 1933. This argument resurfaced after the subprime crisis of 2007-2008 has resulted in the loss of approximately $1.1 trillion, with a dozen and a half large universal banks responsible for half of the losses (Wilmarth Jr, 2009). The global financial meltdown was subverted through the efforts of governments and central banks which subscribed $9 trillion for the support of institutions. The underpinning factor of this crisis was the amount of risk undertaken by too large to fail institutions with funds belonging to individuals (Blundell-Wignall, Atkinson and Roulet, 2014). The argument for the split-up of commercial and investment banking is not clear cut, however the most prominent argument suggest that the separation is necessary to ensure the separation of and protection of customer pledges from market risks (de Larosiere, 2012) ensuring that taxpayer funds are not used to avert risky investments.

The Plight of Modern Markets: How Universal Banking Undermines Capital Markets

This paper explains the process of competitive deregulation that led both the U.S. and the U.K. to embrace universal banking and to abandon the functional separation of financial activities that had long characterized their financial systems. The paper argues that some of the consequences of favoring universal banking over functional separation that were understood in the 1930s were rarely voiced in years preceding deregulation. The principal argument offered in favor of separation was that the commercial banking system, which is supported by a government “safety net,” needs to be protected from the risks inherent in investment banking. By contrast, this paper argues that functional separation played an important role in protecting capital markets from the banking system.Universal banking is associated historically with thinly traded stock markets, and this paper argues that universal banking promotes the formation of a small group of large dealer-banks which dominate the financial system and whose interests are best served by trading on non-public over-the-counter markets. The paper finds that just such a group played a key role in the growing importance of such over-the-counter markets in the U.S. over the past few decades.The paper then argues that the benefits of the greater liquidity that large universal banks can provide to capital markets are offset by the dangers they create when they err. Because mistakes at these large banks are often allowed to grow in size to match the size of the banks, they distort prices on financial markets and sometimes create systemic risk. Two recent examples are given: J.P. Morgan Chase Bank’s “London whale” fiasco and UBS, Merrill Lynch and Citibank’s exposures to subprime mortgages.Finally, the paper explains that the Senate Report on the Glass Steagall Act indicates that the Act was designed in part to limit commercial bank participation in the margin loan market, as this activity makes possible a feedback loop between increases in the money supply and increases in asset prices, which in turn can generate an asset price bubble in capital markets. The recent crisis has led modern researchers to rediscover the relationship between margin lending, feedback loops, and asset price bubbles that was well understood by at least some legislators in the 1930s. The paper argues that the recent crisis demonstrates that modern banking regulation needs to be informed by an understanding of the consequences that may arise when a financial system is dominated by universal banks.

Third Annual Program for Financial Studies Conference Columbia Business School: Navigating the Changing Landscape of Finance

In this edited transcript of his keynote address at Columbia Business School's Third Annual Financial Studies Conference, the Chairman and CEO of Morgan Stanley begins by tracing the origins of the 2008 financial crisis to the overleveraging of bank balance sheets that were filled with risky and illiquid assets. With the leverage of most large banks rising well above 30 times, reductions in asset values of as little as 3% would have been enough to wipe out their capital. And as the value of the assets began to be questioned, so was the banks' ability to roll over their short‐term debt.Contrary to the popular perception, however, the fundamental problem with U.S. banks had almost nothing to with their size, or their complexity. It was in fact the smallest of the large U.S. financial institutions that got into the most trouble—while the largest, JPMorgan Chase, saw the least destruction of value during the crisis. What's more, U.S. banks are relatively small and focused compared to the large universal banks and highly concentrated banking systems that dominate most of the world's developed economies. Complexity itself was not really the culprit either. Some complex banks managed their risks effectively, while many conventional deposit‐takers and lenders failed, reflecting significant differences in the quality and judgment of management.The response of the U.S. government to the crisis, mainly in the form of TARP, proved highly effective in limiting the damage to banks and the global economy. And to reduce the probability of a future banking crisis, U.S. regulators are now well along in implementing a new three‐part regulatory model that consists of the following: (1) significantly higher capital and liquidity requirements that are designed to keep banks from getting into financial trouble; (2) annual report cards called “CCARs” (Comprehensive Review and Analysis) for all banks deemed “systemically important” in which bank balance sheets are subjected to “stress tests” involving scenarios worse than the recent crisis; and (3) “resolution plans” for reorganizing banks that get into trouble and whose capital ratios fall below acceptable levels.Thanks to such regulatory changes, and to the response of most financial institutions to them, the U.S. financial system has been restored to stability. In the case of Morgan Stanley, during the post‐crisis period in which the firm's total assets have been cut by more than a third (from $1.25 trillion to $800 billion), liquid assets have more than doubled (from $80 billion to $180 billion), capital has doubled (from $30 billion to $62 billion), and leverage has been reduced from 35 times to 12 times. At the same time, the firm has shut down proprietary trading and other risky principal businesses while investing heavily in and expanding its most stable business—wealth management—which is expected to account for over 50% of its revenue and profits going forward.

Taking firms to the stock market: IPOs and the importance of large banks in imperial Germany, 1896–1913

Large universal banks played a major role in Germany's industrialization because they provided loans to industry and thereby helped firms to overcome liquidity constraints. Previous research has also argued that they were equally important for the German stock market. This article provides quantitative and qualitative evidence that although the market for underwriters was dominated by a small oligopoly of six large banks, there was still perceptible competition, which kept fees and short‐run profits low. Another interesting finding presented here is the absence of a signalling effect to investors. Neither underpricing nor the one‐year performance was different for the IPOs issued by one of the Big Six. Thus, although the German IPO business was in the hands of a small oligopoly, investors did not benefit from the lack of competition. One explanation is that the quality of IPOs on the German stock market of the time was very good in general as a result of the competition between underwriters, but also as a result of the tight regulation of underwriting, which ensured the quality of all firms on the German stock market.

Universal Banks, Universal Crises? Disentangling Myths from Realities in Quest of a New Regulatory and Supervisory Landscape

The recent financial turmoil has instigated intense debate on the relationship between universal banking and financial stability. Employing legal and financial analysis and drawing on available empirical evidence, this paper critically analyses the arguments for and against universal banking, concluding that it resembles a double-edged knife: it presents opportunities but also bears risks. In this context, a case is made against the complete separation of banking and investment and in favour of a more fine-tuned regulatory regime. The paper suggests that, first and foremost, policy makers need to curb the systemic and systematic risk of large universal banks. From this perspective, the paper suggests that, alongside proportionate regulatory intervention for universal banks constituting systemically important institutions (ie stricter capital, liquidity and risk management requirements, adoption of a special resolution regime and a prompt corrective action procedure), enhancing supervisory effectiveness and market transparency should be top priority in the reform agenda.

Did governance fail universal banks? Moral hazard, risk taking, and banking crises in interwar Italy1

In interwar Italy, at least six major episodes of banking crises required the intervention of monetary authorities to bail out, restructure, or liquidate distressed intermediaries. The five large universal banks rescued in the systemic crisis of 1930–1 jointly accounted for one‐third of the total assets of the banking system. What made Italian leading banks so prone to crises? This article suggests that their fragility was ultimately caused by governance failures, both public and private, that enhanced excess risk‐taking. Empirical evidence is consistent with theoretical insights according to which the potential for moral hazard and conflict of interest, endemic in universal banking, can be magnified when banks enter into long‐run relationships with firms and base their growth strategy on the pursuance of monopolistic rents. Interwar Italy emerges as a case in which an insider system devoid of the disciplinary devices provided by sound governance institutions created perverse incentives and weakened the resilience of the banking system to adverse macroeconomic shocks.

The determinants of recent foreign bank penetration in Brazil

This paper sets out to analyse the determinants of recent foreign bank investments in the Brazilian retail banking market and the strategies of the major European banks in Brazil. Since the recent wave of banking internationalization, financial institutions have continued to pursue their existing relationships while seeking greater integration into local markets. The recent influx of European banks into Latin America and Brazil, meanwhile, has been due to a varied range of factors, including bank restructuring in Europe, the dynamic of internationalization in the Spanish banking system and the process of market deregulation in the region. The paper also stresses some common and specific features of the major European banks in Brazil. One common feature is that they are large universal banks which have chosen to develop abroad as a business expansion strategy.

Consolidation and Strategic Positioning in Banking with Implications for Europe

THE UNPRECEDENTED RESTRUCTURING and consolidation that are occurring around the globe are probably best characterized as a financial services sector in flux. Transactions are particularly numerous and breathtaking in the United States and Western Europe, but restructuring is also occurring in Asia. Most striking is the escalating scale of mergers in banking. In just the last few years, in the United States mergers have led to a consolidation of money center banks (for example, the Chase Manhattan and Chemical Bank merger, prior to their subsequent merger with J. P. Morgan) and the emergence of regional powerhouses (for example, the expansion strategies of BankOne and Nationsbank and their mergers with, respectively, First Chicago/NBD and BankAmerica). In Europe mergers have also been prominent. Although cross-border mergers are relatively infrequent—with exceptions in Scandinavia and the acquisitions across the Dutch-Belgian border, 1 such as the acquisition of the Belgian Bank BBL by the Dutch financial conglomerate ING—domestic mergers typically involve large universal banks and are often spectacular. Noteworthy examples include the marriage of the Union [End Page 37] Bank of Switzerland with Swiss Bank Corporation and the acquisition of Paribas by Banque National de Paris. In Japan spectacular mega-mergers have put the Japanese banks among the largest banks in the world ranked by book value of assets.

Delegated Monitors, Large and Small: Germany's Banking System, 1800–1914

Banks play a greater role in the German financial system than in those of the United States or Britain. Germany's large universal banks are admired by those who advocate bank deregulation in the United States. Others admire the universal banks for their supposed role in corporate governance and industrial finance. Many discussions distort the German banking system by overstressing one of several types of banks, and ignore the competition and cooperation between the famous universal banks and other banking groups. Tracing the historical development of the German banking system from the early nineteenth century places the large universal banks in context.